Money – Protect and Grow

Mutual Fund investments are a great instrument for tax planning which also ensures good returns. In Mutual Funds, a major portion is invested in equity and equity-related instruments. Investment up to Rs 1 lakhs is exempted from income under section 80C and dividends received are also tax-free in the hands of the investor. There is no upper limit on investments and long-term capital appreciations are tax free. The only limitations of Mutual Funds is that there is a lock in of three years before which you can not withdraw. But investment should be carefully planned and you should devote sufficient time in selecting the right fund.

There is no income to the investor during the tenure of the investment. He will get a lump sum amount at the time of redemption or on maturity. In addition to this, investor gets a dividend from the fund house. There are two options available to the investor:

• He can cash in the dividends.

• He can opt for dividend re-investment option.

The most important factor in Mutual Fund investment is the choice of right fund. Check out whether the fund has good performance. Here are some benchmarks to be followed while selecting a Mutual Fund for investment. A good track record is no guarantee for future performance. You should also look at some quantitative measures to evaluate which fund is good for you. Expense Ratio which denotes the annual expenses of the funds, including the management fee, and administrative cost should be low. Higher Sharpe Ratio is better which indicates whether an investment’s return is due to smart investing decisions or a result of excess risk. Alpha Ratio which measures risk relative to the market should be positive. The mutual fund should have a balance in R-square and ideally it should not be more than 90 and less than 80. Final choice depends upon your risk profile and priorities. You should take an investment decision based on overall financial planning.

Here is a list of top five Mutual Funds for the year 2010.

1. HDFC Tax saver

2. Taurus Tax shield

3. Canara Roboco Tax Saver

4. Sahara Tax Gain

5. Reliance Tax Saver

In recent years, money market fund investments have become increasingly popular as investors have become increasingly risk-averse. Particularly, during the recent credit crisis, investors have discovered a sort of safer investments in money market funds as opposed to short-term bonds and traditional savings accounts. However, the drop of the share price of Reserve Primary Fund (RFIXX) below the $1 level (‘breaking the buck’) has shown that money market funds are not the safest of options for risk-averse investors.

Money market funds use the invested money to buy into a large pool of short-term bonds that may include corporate bonds, government bonds or municipal bonds. Unlike other investment vehicles such as stock and bond mutual funds that are subject to price fluctuations, money market funds maintain a net asset value (NAV) of $1.00 per share. This gives investors the feeling that money market mutual funds have virtually no risk.

Money market mutual funds were not supposed to lose their value. Their short-term nature (290 days) provides a considerable level of security against default because, typically, corporate difficulties do not arise in such a short period of time. Theoretically, if a company faces difficulties that would make lending to it a risky option, it would take more than 290 days for the money market mutual funds to exchange their securities at full value. Yet, the default of Lehman Brothers in 2008, the Internet bubble and the implosion of Enron are prominent examples of major companies that defaulted on their debt seemingly overnight.

Money market funds are risky because they are subject to different factors that can drive their price below $1 level. Breaking the buck implies that investors’ returns are less than the invested principal. Indeed, the price decline of the Reserve Primary Fund to 97 cents a share has shown that money market funds can lose their value and be as illiquid as any other mutual fund.

For 2010, analysts cannot estimate accurately when and if there will another surprise related to money market investments. However, there are some factors that are likely to contribute to money market funds ‘breaking the buck’ barrier, affecting their value.

In particular:

a)      Company’s declining assets

Since mid-2009, capital markets have been on an uptrend bull rally as many companies reported profits. On the other hand though, the banking sector continued to fail and job losses continued to mount across several industries. For 2010, the uncertainty is likely to limit investment, while new regulation for investor protection are likely to be implement throughout the year. In such an uncertain and turbulent environment, companies may not be profitable enough to sustain a net asset value of $1.00 in their bonds. If the company whose bonds the money market funds owns faces financial problems, the bonds’ value will decline causing a proportional decline in value in the funds owned by each shareholder.

b)      Investors redeeming simultaneously

In majority, money market funds are invested in short-term bonds that have similar maturity dates. If a large number of investors redeem their money simultaneously, it will create a major problem of liquidity in the market that will cause loss in the value of money market funds. Large simultaneous redemptions could lead a money market fund to sell a part of its assets prior to their maturity date. This may cause a decline in the value of fund.

The truth of the matter is that ‘breaking the buck’ happens all the time. Investors may not realize it because it is not obvious, but considering that they spend their after-tax, after-inflation money, it is certain that by factoring in tax and inflation, money market funds lose their value.  However, as this is more a technical thing, investors seek for the confidence level associated with the fact that the NAV will almost never fall below the $1 level.

Money market mutual funds diversify their short-term investments to protect investors against unexpected difficulties. In doing so, even if one company were to unpredictably default on its debt, the other investments would trade-off for those losses. Besides, in case of a widespread fluctuation in the short-term debt markets, the price of all short-term securities could drop considerably regardless of the financial situation of the individual companies that issued the debt. This explains the “breaking the buck” situation of 2008 where several money market mutual funds collapsed.

Investor expectations in relation to net asset value, particularly after years of consistent NAV, are that a major crisis is required to cause a severe fluctuation in the net asset value of money market funds. However, as investor confidence is shaken, it is possible that, in 2010, money market funds are not an option, unless investors feel protected under new regulations that will allow borrowing and investing with evident reassurance. The Treasury temporarily guaranteed money market mutual funds aiming to put off further investor confidence problems in the short-term debt markets. To that end, the Federal Reserve guarantee that was originally scheduled to expire in October, 2009 has been extended until February 1, 2010.

The main purpose of this article is to increase the awareness of how US taxes capital gains/dividends from International Mutual Funds

US persons invested/considering to invest in Indian Mutual Funds should make themselves aware of how US taxes capital gains/dividends from International Mutual Funds.

Main points are:
•  Mutual Funds in India (or any other country outside US) mostly qualify as Passive Foreign Investment company.
•  These investments need to be declared to IRS every year by June 30th.
•  Capital gains and dividend income from these investments are taxed at the highest Income tax rate and not as capital gains.
•  Additionally deferred taxes (non-payment of taxes till asset is sold to realize capital gain) are charged interest

What is a  Passive Foreign Investment company?

A passive foreign investment company (or “PFIC”) is a foreign company with predominantly investment income, or whose assets are primarily intended to generate investment income. The Internal Revenue Service handles the profits of investments in PFICs differently than their domestic counterparts, so U.S. investors face significant tax implications should they hold ownership of a PFIC.

Classification as a PFIC
Tax code sections 1291 through 1297 provide the rules for U.S. persons who invest in passive foreign investment companies. A foreign corporation is considered a “passive foreign investment company” for these purposes if either one of two tests is satisfied: the Income Test or the Asset Test.
Under the Income Test, a foreign corporation is considered a PFIC if 75 percent or more of the foreign corporation’s gross income for the taxable year consist of passive income. Passive income includes dividends, interest, royalties, rents, annuities, net gains from certain commodities transactions, net foreign currency gains, income equivalent to interest, payments in lieu of dividends, income from notional contracts, and income from certain personal service contracts. Note that the active business of a licensed bank or insurance business is considered active income.
Under the Asset Test, a foreign corporation is considered a PFIC if 50 percent of the foreign corporation’s assets produce – or are held to produce – passive income. In applying the Asset Test, the fair market value of the assets is generally used (the “FMV Method”).
There are two important exceptions to these rules for calculation. First, Congress has recognized that newly-formed corporations frequently hold short-term investments that may create a significant percentage of income prior to the business truly commencing. Likewise, Congress has recognized that a firm that undergoes a change in its business may hold significant temporary assets that generate income, creating a similar situation as a fledling start-up company.

Consequences of Ownership of a PFIC
A U.S. holder of ownership in a passive foreign investment corporation must include as ordinary income the allocated gains or excess distributions in its gross income for the taxable years in which the allocations are made. The tax liability is determined at the highest rate of tax in effect for the applicable taxable year. Additionally, the deferred tax liability from the allocations are treated as underpayments of tax, and interest charges are imposed on the deferred taxes on the allocated gains and excess distributions.